Saturday, November 28, 2009

Getting it wrong over coffee

Money management can be one of the most interesting careers in the world. At best it gives you lots of unstructured time to think about how the world really operates – and to make bets based on your hypotheses. You get to conduct uncontrolled but real time experiments in the social sciences.

But never forget this is social science – not physics – and a little dogmatism about your rules or positions can result in getting it spectacularly wrong.

This was one of the more interesting places I have got it wrong lately – and so I thought I would write it up. It was also a surprising case of getting it wrong – because despite the analysis being totally stuffed I managed to scrape a (small) profit out of the trade.

The case involved three coffee companies (Diedrich, Green Mountain and Peet’s Coffee). I will explain what these companies do later – and how they are involved – but first I want to digress a little on the oddity of American coffee chains.

Starbucks failure in Australia

As an Australian the success of Starbucks (or Peet’s in San Francisco) puzzles me. Australia is blessed with a plethora of interesting and sometimes quirky, often very stylish cafes. For those who are interested here is a photo of my local (Bronte) strip of coffee shops. They are better than any strip I know of in New York, SFO or Chicago. The coffee is better too – and that is widely commented on by visitors to our shores.

It’s not that Australia is even a particularly coffee addicted country. Per capital consumption is not huge by developed country standards and is lower than the United States. We just have a better coffee scene.

It puzzles me why. There are awful lot of things that the United States does (substantially) better than Australia so this is an oddity deserving some explanation.

American coffee chains (particularly Starbucks but also some of the donut variety) have tried to break in and mostly failed. Starbucks closed most of its stores last year after multi-million dollar losses. They couldn’t cope with the Australian competition. Which is odd because in most things the US is a far more competitive market than Australia – and US senior management tend to be more battle hardened than their Australian peers (see my piece on the use of American CEOs in the Australian context). Its just the competition in cafes is far more fierce here.

I would love to be corrected – but I think the reason has to do with our wage structure. American low-end wages are very low indeed whereas Australia has minimum wages at quite high levels. Hiring unskilled labour to run a coffee shop according to a formula (and devoid of in-store entrepreneurial talent) works in America but does not work in Australia. Also entrepreneurial talent in America has too many opportunities to waste itself in a coffee shop – whereas small-time competent entrepreneurs will open a small coffee shop in Australia. [Maybe one of the good things about America is that it uses entrepreneurial talent well.]

Anyway this leads me to believe that some businesses that look bullet proof (running simple chains of shops which sell an addictive and brand loyal product) might actually be more vulnerable to quite strange social and economic trends than you would think. Coffee shops look impregnable (and Peet’s typically trades with a 30 times price earnings ratio) but coffee shops can be beaten back by small entrepreneurial talent for reasons that are hard to articulate.

The Green Mountain Keurig Cup

Another thing that coffee shops are vulnerable to is easy-to-make-at-home quality coffee. Nescafe and other instant brands distribute a large amount of caffeine – as for that matter does the Coca-Cola company. But against a well made espresso (diluted with frothy milk to taste) it just can’t cut it. Our funds management business requires its morning coffee (which we buy from an excellent and entrepreneurial local cafe). That said – American coffee is just not that special – and perhaps is more vulnerable than you think.

One thing it is vulnerable to is the Keurig Cup (or K-cup). K-cups are a plastic and coffee device you put in a special espresso machine and it makes you – instantly and with minimum mess and fuss – a very good espresso with very few traps for the unwary. Its certainly a better drink than instant – and matches in quality a better cafe (though there are some tricks with milk frothing that the k-cup does not match).

K-cups are a truly amazing business. Once you have sold the machine you get to sell the cups (an addictive product no less) ad-infinitum with astonishingly fat margins. And you don’t need to rent expensive real estate to do it. This is like cigarettes – but with a growing market and without the litigation (and without actually killing your customers).

The first time I saw a k-cup was when a pretty young woman in a department store offered me a free coffee (brewed in a k-cup). I noticed the razor-and-blades business model and determined that I did not want to be a sucker to that machine. Alas – and to my endless shame as a stock picker – I did not even consider buying shares in the company which owned the k-cup business. After all as a stock-picker you would really want to be on the receiving end of a razor-and-blade business selling a new addictive product.

That company is Green Mountain Coffee Roasters – and – since I first saw the machine the stock is up over five thousand percent. A five thousand percent gain would – of course – somewhat have improved my finances and the finances of my clients...

The attraction of the k-cup business is not unnoticed by the market – Green Mountain trades at a PE ratio around fifty. Still that is less than one times earnings on the price it was when I first saw a k-cup.

The k-cup license holders and Diedrich Coffee

Four companies have licenses to produce and sell k-cups. Only one of those companies (Diedrich) is listed. A license to sell k-cups is a license to share to some extent in Green Mountain’s very rapid growth however the terms with which you share are unknown. As a default position I would expect that Green Mountain – the technology holder – would extract its pound-of-flesh for granting such a license and whilst a license holder might grow very fast you would not expect it to be outrageously profitable. However – as I said the terms of the license are unknown and have never been published. If Green Mountain – in the infancy of the k-cup business – gave out the licenses on stupid terms then owning one of the four licenses to produce k-cups would be getting most of the benefit of being Green Mountain – but without even the expense of subsidizing the espresso machines or of hiring the pretty-young-woman sales people to sell new espresso machines.

It seemed however unlikely to me that Green Mountain – who have a truly fantastic product – would ever have signed a contract with Diedrich – or anyone else for that matter – which was truly unfavourable. After all Green Mountain held the aces.

Moreover Diedrich has truly strange accounts. It was an unsuccessful owner of a coffee shop chain (Gloria Jeans) which they sold off and the balance sheet has about 50 million in accumulated losses. Sales were flying – but half those sales were back to Green Mountain (for whom they out manufactured product). Moreover the accounts were truly strange in other ways (it was for instance very difficult to get a handle on tax expense). There was a truly frightening article that appeared on Seeking Alpha which went through the accounts in great detail – and – if you took all the suggestions in that article at face value – then you would probably conclude that Diedrich was a fraud. (The Seeking Alpha article has since been removed.)

None of that stoped Diedrich being a truly explosive stock – indeed before I had even looked at the stock (and in about six months) it has gone from 21c to just over $30. You don’t need too many of them in your lifetime…

Now this move looked truly bizarre given (a) the fact that it did not even own the k-cup technology and (b) the bizarre accounting as outlined in the Seeking Alpha article.

I thought (possibly incorrectly) that Diedrich was probably a stock-promote rather than a business as per the suggestion in the Seeking Alpha article – but I did not bother to do any of the work to prove or disprove that case. That work came later.

The Seeking Alpha article was anonymous and hard to verify (as discussed below).

The danger of shorting frauds

The reason I did not do any of the work to confirm or deny the Seeking Alpha article was that shorting frauds (especially well publicised frauds) is possibly the most dangerous thing you can do on Wall Street. Take for example a fraudulent oil company in Africa – but one that really has some oil. The company has oil – so it can show flows to visiting analysts. It has pictures and local politicians are excited to hob-nob with the management. But there is no real way of telling whether they have 1 million barrels or 10 million barrels. They may have 3 million barrels (which would be valuable – but not earth shattering) but tell the market they have 20 million barrels. There really are very few ways to tell – and if they are determined they can exaggerate at will. Moreover suppose you have worked it out (or at least have suspicions) – it doesn’t help you. If someone is going to fake the existence of 17 million barrels of oil there is not much that stops them from faking the existence of 170 million barrels of oil. If you are short and they “announced” a 100 million barrels (or a few trillion cubic feet of gas) and the market believes them then you are stuffed. The stock could go for a monstrous run – and you will be forced to cover at a shocking loss.

The problem with shorting frauds is that there is nothing to keep the fraud grounded – and hence there is nothing to limit your losses. If you short a real company (say Dell) and Dell sells less computers than it anticipated it will tell the market. The stock will probably go down. If it sells more computers than anticipated at better margins the stock will go up. But it is vanishingly unlikely to sell ten times as many computers as anticipated. You can be short and whilst you might lose money if you are wrong you will not do serious damage. Frauds – because there is nothing to keep the claims grounded – can cost you an enormous amount as a short.

There was a possibility that Diedrich was a fraud – but it was a high-growth with a substantial short interest. There was simply no way that I was going to short it because the potential losses looked vast. Given that I did not bother to fact-check the Seeking Alpha article.

The rare safe time to short a fraud

There is only one time that it is relatively safe to short a fraud – and that is when a real company is suckered into buying it. That happens – and the cannon-example was when Mattel purchased The Learning Company.

The Learning Company (TLC) was (and remains) a children’s educational game software maker. It has real games and real sales. In that sense it was similar to my African oil company with a few million barrels. It however had accounts which were peculiar – and several short sellers were convinced it was mostly fraudulent. [I had never heard of the company so I cannot vouch for their views.]

Eventually Mattel purchased TLC. The purchase was made from weakness. Mattel used to have a great franchise in toys for young boys (think Matchbox cars). There is simply no way I could interest my nine year old in Matchbox cars anymore – not when they have a Playstation or a Wii. Boys toys were dead and computer games killed them.

Mattel was desperate to join the computer game revolution – and it paid a fortune for what really was a dodgy property. The losses were in the billions. Wikipedia tells the story quite well. It was one of the worst acquisitions ever on Wall Street – and not only did it cost Mattel over 3.5 billion (mostly in stock) but it revealed the underlying (and fundamentally incurable) weakness in Mattel’s business. It also cost the CEO (Jill Barad) her job. Jill made her career promoting and marketing Barbie dolls and her claim to fame was that she was brilliant – possibly amongst the best ever – at marketing bimbos. (A company insider once noted to me that that included herself.) Jill was however absolutely useless at assessing a computer game company. [Personally though I think she should have been kept on as CEO but limited to Barbie… She really did deserve that job and did it well.]

A short seller’s dream is when a real company – preferably one which is a little dopey and in an old industry (matchbox cars as compared to computer games) buys something hot, sexy and fundamentally dodgy.

Peet’s bids for Diedrich

I thought I had my own repeat of Mattel and The Learning Company. Peet’s – a well run but simple coffee chain around the Bay Area bid cash (debt funded) and stock to buy Diedrich. Ah – here it was – a simple company with a simple model – whose margins seemed to be declining (for reasons I have not fully identified) which bids for a well promoted company with massively complex (and potentially misleading) accounts.

To say I was excited is understating it. This is precisely the sort of thing that excites a short seller. At worst what would happen was that Peet’s – a company with less than 200 coffee shops (and owning only the brand and fittings) would have roughly 140 million debt and a business (Diedrich) that – depending on the contract with Green Mountain – might not be worth very much at all.

In the bad-case Peet’s stock – trading at 30 times earnings – could lose 80 percent of its value. [That was what happened to Mattel.]

So I did some work. I went back to the Seeking Alpha article and tried to verify every claim in it. Alas I could not. There were a few simple (and innocent) explanations for some of the red-flags highlighted in the Seeking Alpha article. However with respect to some of the claims in the article I had to acknowledge that the author had a point. He wasn’t right with respect to everything – but he was right on some points. Diedrich’s accounts were (and still are) pretty aggressively stated.

I shorted some Peet’s. Not a lot – but maybe a third of the final position I hoped to have. I intended to do a little more work (especially as the debt covenants were published). Besides – in the Mattel case there were many quarters as The Learning Company disaster unfolded. There were plenty of opportunities for a short seller in Mattel to test their thesis on the way down. This was a small position – but as it unfolded I hoped to make it a big position.

Now the observant will notice there is a missing detail. I still do not know the terms of the contract between Green Mountain and Diedrich. If the terms are highly favourable to Diedrich then shorting Diedrich (or the new owner of Diedrich) is spectacularly misguided. In that case Diedrich is just a cheap way into Green Mountain’s (fantastic) business.

Not knowing the terms of that contract was the key weakness in all of my analysis. And I knew it.

Peet’s had a conference call when they announced the purchase. They indicated that the terms of the contract were acceptable but they refused to detail what they were. Paraphrasing Mandy Rice Davies “well they would say that wouldn’t they”.

What I was looking for in future quarters (as a guide to increasing the position) was evidence that the Green Mountain contract was favourable to Green Mountain.

Well I was wrong

I started this by stating that most of the analysis was wrong. And it was – in a very specific way. My biggest concern was always the contract Green Mountain had with Diedrich. And only one party outside Diedrich knows that contract and understands its economics intimately. That is Green Mountain.

Oops – now I know I am wrong. Green Mountain wants to bring that contract back in house. They want it in-house for about a quarter of a billion dollars in cash! Remember ultimately all that Diedrich has is a few tax losses, a small manufacturing facility for K-cups, a couple of second-rate coffee brands and THAT CONTRACT.

Peet’s overbid – bidding $32 a share ($20 in cash the rest in stock). Green Mountain upped its bid to $32 per share ($265 million) all cash. Remember this stock was trading earlier this year under 25 cents! This is one hell-of-a-valuable contract.

Needless to say events have shown I was wrong about Diedrich with respect to the only thing that mattered (the worth of the k-cup contract with Green Mountain). I covered my short and thanked luck that it was not (much) worse.

Of course this bidding war drove down the value of Peet’s stock. So I was wrong and made a small profit.

Money management – lucky or smart?

Given I was wrong I can hardly say I was smart. But Peet’s was not a bad candidate for a short. It has a very thin balance sheet (almost all profits have been used to buy back stock). It does not own the sites of its stores. It was paying cash so it was going to incur debt with only intangible assets (its brand really) to back that debt. And it had a 30 PE.

Given all of that I could be wrong in lots of ways but still make a profit.

But I should not get carried away. I was wrong – proven wrong – and the profit is nice but it shouldn’t be used to ignore the fact that my hypothesis was simply inconsistent with observation.

Back to scratching around (often fruitlessly) for things that might make money.

This is a sidebar, but the founder of Diedrich (Martin Diedrich) has since started a fantastic small chain of coffee shops (Kean Coffee - http://www.keancoffee.com/). I met him one day when he was wiping down his own tables.

He told me that he basically was pushed out of the operations of the business by the investors and ended up with a minority share and no control over operations.

If you're ever in Orange County, CA try to visit his coffee shop. It's both popular and very good.

Great post. But do you really think those machines make good coffee? We have one in the office, and even though it's free, nobody uses it. Which shows 2 things -- 1. the cafes in NYC are getting pretty good (have you tried Gorilla or Stumptown?). 2. Coffee is as much a ritual as a beverage, and people like going out into public to fetch it. Particularly if it means getting away from their desks.

Competition in SBUX country is so keen that a small start-up chain resorted to baristas in g-strings. Needless to say, the evangelicals (small minority) in godless King County want them shut down. The politicians are claiming the tips (much more than the cost of a latte) aren't being taxed.

The explanation I've read for the failure of Starbucks in Australia was that Australia has a relatively large Italian population, and these Italian-Australians brought with them some of Italy's coffee culture.

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John,An excellent post, and interesting that Green Mountain was the best performing stock of the last decade according to Crossing Wall Street - http://www.crossingwallstreet.com/archives/2009/11/top_stocks_of_t.html

As the promoter of the Texas Holdem Investing theory of investing education I find it encouraging as to how you describe money management as providing the opportunity to "make bets" on a hypothesis regarding the real world.

Texas Holdem Investing gets the investor to try to frame each investment as a thesis and play the investment out based on how the security evolves relative to the thesis.

Rather like forming a thesis based on your pocket cards in Texas Holdem and then playing the flop, turn, and river based on how the rest of the game plays out relative to your thesis.

John, you seem to have played your Green Mountain game well, because although you may have mistakes early in the game you got out quickly after the real world evolved differently to your thesis. Many lesser investors would have stayed in the game and significantly increased their ruin probability.

Johnvery good post! And good introspection of the shorting dynamics...but...do not forget Australians have learned how to make coffee the "Italian way" ( freshly grounded, machine skills required etc...) well before Starbucks started putting Australia on the map.....Frankly why would your friends in Bronte trade down to a Starbuck...?Also I would argue that "unskilled" labour do not qualify by definition to work behind a coffee machine (in Australia). You rarely see the "temp" behind the machine in Sydney. He's either the owner or a long-term employee... So it's not the wage structure the factor, but simply the local product is different(and better..sorry guys in NY).

Said that, you may be interested to know that Nestle's capsules ( seemingly on a separate patent) in the US cost the same (55 cents) as K-cups.... and Kraft (Tassimo) and Philips+Sara Lee (Senseo) charge even less....So perhaps where the fraud did not work, competition will...in the long term... http://www.businessweek.com/globalbiz/content/mar2009/gb20090324_886251.htm

I believe that I have a little insight on the American coffee market. I have consumed vast amounts of coffee from both Starbucks (and related brands) as well as independent coffee shops. In fact in Seattle I lived near Vivace, a famous US coffee house. While in Seattle I split my coffee consumption between Starbucks (on my way to work, usually at the first Starbucks in Pike Place Market) and a variety of other coffee shops (all other times). I really enjoy sitting in a coffee shop and working.

However sitting in San Jose there are very few good coffee shops and I would have to drive out of my way to go to one. I think that if you look at the other businesses around a coffee shops you can learn a lot. The independent coffee shops that I enjoy are typically found amongst collections of other small businesses, usually in larger and denser cities. Starbucks can be found in large cities also usually near the major business areas (where other larger corporate establishments are found) but Starbucks are also in strip malls in the county. Given American commute patterns I don't find it strange that Starbucks flourishes in America as opposed to the rest of the world. I think that not everyone in America is able to appreciate a finely crafted cup of coffee and those that are and are willing to wait for it are typically found in great enough density in cities to support a coffee shop.

it is only barely possible to get a good cup of coffee in new york. i know -- i live in new york after having lived in seattle, where i am currently visiting. there is an uptown espresso a block from my hotel, and the well trained baristas serve great coffee, consistently, with a friendly unhurried atmosphere. none of these things are thinkable in new york.

gorilla is barely drinkable (wildly overrated imho) and stumptown is very good on the west coast but their new york operations have serious problems. i live five blocks from their flagship brooklyn store and every cup i get from them is a different experience. i've had tepid milk in my cappucino more than once.

they are the best in the neighborhood though, so people keep coming back. ie there is no real competition.

this is to say that there are complicated cultural and economic factors - real estate prices, existence of a young and friendly trainable population, knowledgeable (ie opinionated and snobby) customers and above all a competitive environment - that lead to the flourishing of an independent coffeehouse culture.

starbucks is a very strong brand in the new york area - to many people it is synonymous with coffee drinks. many nj mall rats consider it synonymous with civilization itself. never mind that the coffee isn't great. (that's also related to costs -- they intentionally burn their coffee reduce storage costs and reduce the ability of an untrained barista to screw things up.

the automated coffeemaking front is interesting. a coffeehouse in brooklyn has a clover machine and it produces a tidy cup of coffee with no expertise whatsoever. it's not bad, more interesting than good, but i take it over stumptown sometimes.

i venture that automated home food production (ie specialty stoves that cook food for you, monitoring things closely to produce a good result) is going to be a big growth industry at some point in the 21st century, but i don't know when.

One correction with respect to the American labor/coffee market - hiring unskilled labor to work in your coffee shop used to be effective for Starbucks. America has a huge amount of under-utilized service talent in college/grad students who are too much of slackers to find a real job (I've been in this position) and under-educated but pragmatically-skilled minorities (I haven't been in this position but I've met plenty of guys who would be $100k/year salesmen instead of counter workers if they were white college graduates).

Starbucks used to get these workers but at least in my NYC experience they now get the same people who work at McDonald's (worst of the employable and some who probably should not be employed). The cream of the low-paid, low-skill crop wants to work somewhere that they feel good about. It feels much cooler to work at the funky coffeeshop near campus where you can play your own music than to push Norah Jones CDs at the Starbucks. Starbucks used to have the "cool-place-to-work" reputation but lost it in the face of over-expansion, over-corporatization, and increased competition from local shops.

Some of the most successful consumer-facing companies are those who can appeal to the highest-potential unskilled laborers. Whole Foods does well in part because they pay the guy who cuts the fish a couple bucks extra and treat him a little nicer. As a customer, you then get to meet the world's most charismatic guy who only knows how to cut fish instead of a sullen, overweight teenager who screws up your fillet because he really doesn't care. The good reputation of Whole Foods does a lot of the work in getting the higher-quality guy to work there instead of the other supermarket down the block. It also means that sometimes the bagger is a pedantic hippie who wants to talk to you about burdocks rather than someone who can get the milk and bread into separate bags, but a lot of people prefer to shop in this kind of store.

One detail on the contract from the Diedrich investor presentation page 13 July 2009 Corporate Presentation:

"Agreement expires July 2013 and “Evergreens” thereafter based upon certain volume thresholds, which are currently being exceeded"

It's pretty well known that is 6+ cents royalty per every K-Cup. Maybe they think it would be easier to hit the thresholds with Peet's behind it? Not sure if the contract explanation is the motivation... They always talk about a razor blade model of selling the brewers at costs and collecting royalties. How does keeping the contract in house further that along?

I believe Starbucks failed mainly due to 2 reasons. 1) Many coffee businesses are not big enough to be run "under management". They deliver enough profit usually to a mum/dad investor. (E.g. 150-200k). The profit is not big because of fierce competition but also because there are not enough people per SQm2. In cities like NY, LA, the density of the population means most coffee shops are able to be run under management and be profitable.

2) Wages are higher in Australia, and there's more benefits (super) being paid out to Australian workers vs their US counterparts. Coffee is a numbers game and there is very little room to move on selling low priced items. It is my belief that these two are reasons why Starbucks was unable to monetize in Australia.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.